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March 26, 2013

Currency Manager Merk on Cyprus and Why PIMCO’s El-Erian Is Wrong

Merk doesn’t buy PIMCO chief's argument that time will heal crisis

Merk Funds president and CIO Axel Merk is certainly qualified to make sense of the Cypriot mess, and he attempts to do just that in his latest commentary. Specifically, he wonders why gold isn’t going through the roof as a hedge against all that ails the island nation, and by extension Europe itself.

“Had those with money tied up in the Cypriot banking system owned gold instead, they might have been able to watch the unfolding crisis relaxing on the beach,” Merk (left) writes, before positing, “So why isn’t gold going through the roof? Is Cyprus too small to matter? Can it happen in the U.S.? Should investors hold gold?”

First, be aware that bank failures do happen, he notes, in Cyprus and the United States alike.

“A bank deposit is nothing but a loan to the bank. To the extent that these deposits are guaranteed, the creditworthiness of the guarantor should be considered. In Cyprus, the government guaranteed deposits up to 100,000 euros [about $128,500]; in the U.S., the FDIC guarantees deposits up to $250,000.”

He adds that in the United Sates, unlike in Cyprus, there is a well-defined process to seize and unwind insolvent banks. Crises will happen, but they are less stressful when sound institutional processes are in place. The other key difference is that U.S. banks have generally rebuilt their balance sheets, whereas some European banks have dragged their feet, hiding behind national regulators.

“To deal with excessive debt loads, the Eurozone imposes a mix of austerity and restructuring; restructuring is a fancy word for defaulting on one’s obligations. When deposits are lost, depositors get to experience financial repression rather directly.”

In the Unites States, in contrast, financial repression is exerted less explicitly by imposing negative real interest rates on savers.

Addressing Mohamed El-Erian’s argument that savers don’t revolt, thus making them an easy target, he noted that El-Erian, at a recent speech at Stanford University, also appeared to suggest the United Sates will heal if the Federal Reserve only “buys enough time.”

“We don’t believe buying time will prompt our policymakers to get their act together,” Merk counters. He then turns back to the question of gold, and why prices are not rising, by addressing conventional wisdom:

The Eurozone banking crisis is contained. “As fear flares up that those holding large deposits in Italian banks might be at risk, such contagion might flare up, potentially propelling gold higher. However, keep in mind that unlike Russian money that had few other places to go (few banks welcome Russian money these days), Italian savers have long had the opportunity to move money abroad. Italian banks have taken actions to bolster their balance sheets. Having said that, given the slow-motion drama on display in Cyprus, markets are likely to remain nervous.”

Interest rates may rise. “One reason why gold has been trending sideways for a considerable period now is that investors might expect the Federal Reserve to embark on its “exit”; the argument is that as the economy grows, negative real rates might turn into positive ones, thus yielding more than gold. We agree that should the world embark on a major tightening cycle, it may spell bad news for the price of gold.”

There is no inflation. “Depending on the metric one looks at, inflation expectations are reasonably well ‘contained,’ although such inflation expectations inched when the Fed decided to embrace an unemployment target. However, the only person for whom the average cost of living might have been declining just about each year over the past decade is a person living on their personal gold standard. Personally, I hold about half of my non-real-estate investments in gold.”

Japan. “Japan’s finance minister wants to borrow from the toolbox of the Great Depression in pursuing fiscal policy. The Bank of Japan wants to achieve a 2% inflation rate within two years and is about to announce concrete steps to get it there. With a debt-to-GDP ratio exceeding 200%, we don’t see how the bond market can support a 2% inflation rate.

United Kingdom. “The United Kingdom is paving the way for incoming Bank of England (and outgoing Bank of Canada) Governor Carney to increase the BoE’s inflation target or to engage in nominal GDP targeting. The UK already suffers from stagflation; again, upcoming BoE’s policy may well have a bigger impact on the price of gold than a typical day in the Eurozone where Italian savers grind their teeth.”

United States. “In our assessment, without meaningful entitlement reform, the U.S. will go bankrupt. We are actually optimistic that entitlement reform will come; however, we don’t think it will come before the bond market pressures policymakers into action.”